Christine Benz: Hi. I’m Christine Benz for Morningstar.com. In certain cases Morningstar’s forward-looking Analyst Ratings might seem to run counter to funds' near-term performance. Joining me to discuss some examples of that is Shannon Zimmerman. He is associate director of fund analysis with Morningstar.

Shannon, thank you so much for being here.

Shannon Zimmerman: Good to be with you, Christine.

Benz: Shannon, first, let’s talk about how the analysts come about their forward-looking ratings. What sorts of factors are they taking into account?

Zimmerman: We have five analytical pillars, so among the things that we look at are the people who run the fund and the analyst team that support the managers of the fund; price; performance; process; and the parent company behind the fund, too, because if there is not a strong investment culture at the parent company, that can trickle down to the day-to-day running of the mutual fund, as well. So those are the five areas that we look into. Then, as you say, our assessment doesn’t always match up certainly with recent performance.

Benz: So performance is one of those pillars, but just one. So let’s take a look at a few examples of funds that have had maybe not great recent performance but that we still give very high ratings to. Let’s start with Dodge & Cox Stock. It’s a name that’s well-known to a lot of our viewers. Let’s talk about what’s been going on with that particular fund over the past three and five-year periods, and also why we still have conviction in that fund’s ability to outperform.

Zimmerman: Well, the reason we have conviction is, it has a fine long-term track record. The management team is very experienced, and the longest senior manager on the fund started in 1977, John Gunn. It has low costs, and we found in our research, an expense ratio can be quite predictive of outperformance if it's below-average in cost, and of underperformance if it’s above-average. They prize intensive, pain-staking research. They are very much focused on fundamentals and are not trying to make sector calls in terms of what’s going up and what’s going down. They just focus on individual businesses to invest in for the long haul, and it’s a Gold-rated fund for us from the Analyst Rating perspective.

But over the last five years, it’s below-average in its category. I think it’s in 53rd percentile over the last five years in the large-value category, and just outside the top third over the three-year period. So if we were only looking exclusively at performance, well, then we wouldn’t have an Analyst Rating; we would just rely on the Morningstar Rating for funds. But in this case, the analyst who covers it, Dan Culloton, my colleague, thinks that the forward-looking prospects for the fund are quite strong, and it’s hard to argue with him. It’s a Gold-rated fund despite the sort of subpar recent performance.

Benz: One thing that I think maybe tarnished some investors’ faith in this fund was its 2008 showing. People always thought of it as kind of a defensive, as you say, value-minded fund. But its losses were, in fact, quite large during that period. Does that shake your confidence in the fund or in the process there?

Zimmerman: It doesn’t shake our confidence, but I think that that was a clarifying experience for a lot of people. It’s a large-value fund and a lot of times folks think, well, that’s a button-down category; not so. I mean, there are long-term investors with a contrarian bent at times, as well. And as with any contrarian, it could take a while for things to pan out, and value investors have a knack for getting in too early rather and getting out too soon. And that happened with Dodge & Cox Stock with their exposure to financials. But they didn’t blink. They didn't double down, but they increased their position to some or foundering financials coming out of the 2008 meltdown, and that’s been rewarded since then.

Benz: Shannon, let’s take a look at another fund. This is one that you cover. It’s arguably a more specialized fund than Dodge & Cox Stock. It’s one that you’ve got a strong rating on a forward-looking basis for the fund. But near-term performance has not been that hot.

Zimmerman: That’s right. It’s a Silver-rated fund, and the five-year performance is actually subpar, below the category average for mid-cap blend funds. Its three-year number is in the 41st percentile now, so [there has been] a little bounce-back, but it's still kind of a soft patch for the fund. But as you point out, and I try to point it out every time I write about the fund, it is a niche product, the Fidelity Leveraged Company Stock. The manager there, Tom Soviero, comes from the high-yield side of Fidelity and now is managing exclusively equity money, but using a lot of the same research that he used when he was on the high-yield scene.

So these are highly leveraged companies, and in a market like 2008, which the five-year number still reflects, you would expect a fund like this to do quite poorly. But then in 2009, it didn’t fully recover from its 2008 losses. But I think in 2008 it lost around 53%, and in 2009 it made about 59%. Again, that's exactly as you would expect it to perform, and that’s the reason why I feel confident enough to give it a Silver rating despite the soft patch because if you look at the long-term track record of the fund under the manager, in every market where you think it would outperform, it does, and in every market where you think it would underperform, it does. So it’s perfectly predictable, and if investors have the stomach for a lot of volatility, they should be able to do quite well. If you look at the 10-year return here, I think it’s number two of all equity funds over the last 10 years. But investors haven’t been able to use this fund very well. In fact, it’s done about 14% annualized over the last decade, and the typical investor has only gotten about 2% of that. So you really have to have calm nerves and not be a quarterly performance report junkie to do well with this fund.

Benz: So let’s discuss the flip side of this issue. So these are funds where we have Negative or Neutral ratings on the funds, but near-term performance has really been quite good. Let’s start by looking at Vanguard Windsor. It’s a big, venerable name. Let’s talk about the analyst outlook for that fund and what has driven the recent performance.

Zimmerman: Sure. So Vanguard Windsor is in the 17th percentile over the last five years, so it has quite strong returns over that period. If we were focused just on returns, well, we would just be aligned with the star rating. But that’s not the case here. In August 2012, Vanguard made a major shift and took AllianceBernstein, which had been a subadvisor on the fund, off the fund and gave it to [Pzena Investment Management]. Now, we think that on balance is an upgrade, but it’s a little too soon to tell if it’s going to work as well as Vanguard hopes and as well as we think it might.

But what is pretty clear from looking at Rich Pzena’s track record at his own funds and others that his team manages is that it has a deep-value contrarian style. There can be long periods where that strategy kind of wanders in the wilderness, and this is a fund that, even before Pzena arrived and his team arrived on the management team, was quite volatile. Given the deep-value style that Pzena practices and the concentrated approach he takes at portfolio construction, that’s likely to at least continue or perhaps be exacerbated.

Benz: So we’ve got a Neutral rating on this one rather than Negative.

Zimmerman: That’s right.

Benz: I assume that the low costs are at least a big point in its favor.

Zimmerman: Right. This is an interesting fund to me because we generally admire Vanguard for numerous reasons, but low cost would certainly be at the top of that list.

Benz: Sure. The last fund I want to talk about is Gabelli Small Cap Growth. That’s a fund where it has had strong recent performance, and yet we do not rate it particularly highly either.

Zimmerman: Right. A big reason is the price tag. It’s 141 basis points, 1.41%, in a category where the median is 1.22%, 122 basis points. So it has considerably above-average costs relative to the broad category but then also relative to funds that are distributor-sold in the same way. Our research has shown that a fund’s expense ratio can be one of the most predictive things in terms of whether or not it’s going to be able to outperform its typical peer, and in some ways that’s common sense because expenses are forgone returns for the investor. And so higher the price tag, the lower the returns are necessarily going to be. So at 141 basis points, that’s pretty big hurdle for the manager to overcome. Now, Mario Gabelli is one of the most experienced managers in the industry. He’s been at it for a long time, and he is on this fund. That is a point in its favor; however, he manages 15 other funds, as well. And our analyst who covers the fund, Flynn Murphy, says it’s right for investors to be worried about succession, and I agree with Flynn.

Benz: Shannon, thank you so much for being here to provide an overview of the situations where our Analyst Rating collides with recent performance.